Tuesday was a bad day for Blockbuster shareholders. Open to close, the company’s stock crashed 77%, dropping from 96 cents to 22 cents a share. The massive sell-off was triggered after reports circulated saying the company hired Chicago law firm Kirkland & Ellis to explore a possible bankruptcy filing.

In rebuttal, Blockbuster told a different tale about its intentions for the retainer. The company says it hired counsel to help with restructuring and not to prepare for court protection.

Did the reports get it wrong? Or did traders rush to action too fast, misinterpreting the news along the way?

Karen Raskopf, Blockbuster’s spokeswoman, said the company hired Kirkland & Ellis “for assistance with our ongoing finance and capital-raising initiative." Regarding Blockbuster’s plans, she said, “We do not intend to file for bankruptcy."

Blockbuster’s “ongoing financing” issues aren’t anything new. With more than 7,500 global retail stores (5,343 of which are company operated), the company carries significant operational overhead in a competitive and changing sector. The company is also burdened with a large, maturing debt load.

November earnings documents show $300m in Term B loans are due in 2012. Another Term A Loan and a revolving credit facility are set to expire this coming August.

Blockbuster has been looking to set up a new “revolver” but CFO Thomas Casey acknowledged in the company’s November earnings call (transcript) that “the current state of banking and overall credit environment certainly muddies the outlook for that event.”

As a contingency, the company is in a “in a position to implement a capital management plan, if necessary, to self fund [the] business through 2009,” he said.

That prospect was further validated in the company’s 10K. In the filing, Blockbuster said it was already in preliminary discussions with potential lenders but would also be taking “prudent actions” to ensure cash on hand and from operations would be “sufficient to fund all of our anticipated cash requirements for at least the next twelve months” if a new revolving credit agreement wasn’t reached.

Given those contingencies, near term liquidity doesn’t appear to be an issue.

What may be a more substantial concern for Blockbuster’s prospects this year are its debt covenant issues. Per the 2004 Loan Agreement (original SEC Filing Here, see Section VI), Blockbuster is required to maintain a Leverage Ratio in set ranges and also keep a Fixed Charge Coverage Ratio above certain thresholds. If these performance benchmarks are missed, and creditors aren’t willing to defer the requirements, Blockbuster could find itself in default. (Ed. Note: the Loan Agreement has been amended multiple times including creditor deferral of the covenant requirements).

Enter Kirkland & Ellis. The 7th largest US law firm (by revenue) is best known for its litigation practice but is also well regarded for its Corporate & Tax Practice and its Restructuring group.

Even though it’s true the firm has handled massive bankruptcies, including famously, United Airlines and TWA, it has a track record representing creditors and debtors in far less dire scenarios including secured financings. The firm has the experience to provide guidance for a company looking to weigh its options.

In Blockbuster’s case, in fact, the firm brings even more to the table: Kirkland & Ellis represented Blockbuster’s competitor Movie Gallery in its restructuring. (Movie Gallery, which also includes the Hollywood Video brand, filed Chapter 11 in 2007 and came out of bankruptcy in May 2008). That’s directly relevant market/situational experience no other firm could likely offer.

Hiring Kirkland could well turn out to be prudent due diligence for Blockbuster regardless of the course it follows.

Blockbuster plans to discuss its financing situation in more detail when it announces its earnings on March 19th. Until then, the definitive statement seems to be the words of Blockbuster’s spokeswoman: “We do not intend to file for bankruptcy."

So what’s the cost if initial reports turn out to have misinterpreted Blockkbuster’s decision to hire the firm; the cost if articles overstated what retaining the law firm really means? $142.8 million is one number. That’s the market capitalization that flushed away in Tuesday’s market reaction.